Credit: Rob Dobi
Ideas Made to Matter
Decentralized finance: 4 challenges to consider
What would a world without banks look like? That’s the premise of decentralized finance, a $77 billion market that has been touted as a more efficient alternative to traditional banking.
In a DeFi world, cryptocurrency-backed transactions are executed automatically and blockchain-based smart contracts allow people to trade directly with each other without oversight of big banks — or any banks.
“The distributed ledger technology at the heart of cryptocurrency and DeFi is a core innovation that can potentially change the architecture of our existing financial infrastructure,” said MIT Sloan finance professora cryptocurrency researcher and co-director of the National Bureau of Economic Research’s Corporate Finance program.
Historically, intermediaries — such as commercial and investment banks, stockbrokers, and pooled investment funds — played a critical role in the financial system. Now, “this new financial infrastructure proposes to get rid of the intermediaries and institutions and replace them with a network of decentralized participants on the blockchain, especially in DeFi,” Schoar explained.
The market for decentralized finance is valued at $77 billion, according to crypto analytics firm DeFi Pulse.
Cryptocurrency enthusiasts applaud decentralized finance as a way to democratize finance. By replacing traditional financial institutions and banking fees with public blockchains and open-source software, just about anyone with an Internet connection can participate for free, advocates argue.
In a new working paper, “Cryptocurrencies and Decentralized Finance,” Schoar and co-author Igor Makarov of the London School of Economics unpack those claims, and others.
DeFi, the authors write, has the potential to revolutionize the financial sector, but there are still many challenges that must be addressed first, such as transparency and regulation.
Given that DeFi is mostly unregulated, it is a magnet for fraud and money laundering and lacks consumer safeguards that exist in traditional finance. In 2021, for instance, more than $10 billion was lost to DeFi scams, according to research from Elliptic, a blockchain analytics firm.
Even so, DeFi offers plenty of opportunity and promise. Here are four takeaways from the researchers to keep in mind:
1. DeFi isn’t an even playing field.
Despite its promise of democratizing access, Schoar said it’s “quite naive to believe” that DeFi will automatically level the playing field. Financial markets are inherently prone to economies of scale and scope as well as large network externalities, she said. These forces create pressures for concentration even if there is free market entry.
For example, given the importance of liquidity for exchanges, traders will always try to execute their order on the deepest and most liquid exchange. But this gives the exchange the power to charge high fees. “We start seeing the same dynamic in DeFi markets. Dominant exchanges charge high fees and try to protect their dominant position in the market.”
Even in the world of DeFi, dominant exchanges try to limit access to their trade secrets in order to make competition more difficult, as the battle between Uniswap and SushiSwap shows. “Once you have dominant exchanges, even if others can seamlessly enter, they will find it difficult to dislodge them,” she said.
2. It’s difficult to collect taxes.
Transactions made using digital currencies are taxable, but reporting them isn’t easy, even for the well-intended, the researchers say, given that DeFi is predominantly built on permissionless and pseudonymous blockchains. In fact, one estimate from Barclays suggests the IRS may be missing out on $50 billion a year in unpaid crypto taxes because it’s difficult to trace crypto transactions and collect tax.
“In the DeFi world, it’s difficult to enforce taxes. There are no intermediaries that have the infrastructure to enforce taxes and verify who you are and then send a 1088 tax form, or a capital gains notification to the IRS,” Schoar said. “Even for people who want to do all the right things, it’s very inconvenient.”
Schoar said there may someday be software to calculate a person’s crypto tax. This can help people who want to self-report taxes. But it’s easy for people to evade a tax on crypto, thereby “giving one part of the financial sector a huge subsidy over the traditional financial sector where we do collect taxes.”
3. Governance issues plague the sector.
Unlike traditional finance, DeFi governance takes place via decentralized autonomous organizations. A DAO spreads decision-making power among all interested stakeholders, sort of like a crypto co-op, with a community of users voting on proposals using crypto tokens.
However, that setup isn’t immune to the same governance challenges that have plagued the crypto space more generally. For example, the first-ever DAO (known as The DAO) raised more than $150 million but faced numerous governance problems and was later delisted.
In addition, the authors said that if investors with large stakes (known as “blockholders”) gained enough control to impose their views on the system, it would be hard to enforce penalties, given blockchain’s anonymity.
“There has been little evidence so far to suggest that the crypto space can successfully resolve governance issues without relying on some off-chain mechanisms,” the authors write, referring to the world outside of blockchain.
“Given that governance issues of blockchain platforms and traditional financial firms are not materially different, it is very likely that robust governance mechanisms will require the support of external regulation,” they write.
4. Global regulatory coordination could be stronger.
Cryptocurrency and DeFi regulations differ internationally, but Schoar said having stronger regulatory global coordination would help cut down on fraud.
“There are disparate efforts in regulations between Europe and the U.S., and I think Europe is further along than the U.S.,” Schoar said. “Some of it has to do with the fact that in the U.S., there’s so many potential regulators who interface with crypto that have to coordinate. That makes coordination very difficult but also creates turf battles.”
Schoar said that there are ways to regulate the DeFi system that would preserve most of the features of blockchain architecture but encourage accountability and regulatory compliance. For example, validators on the blockchain could be required to check that a particular address belongs to a certified entity, then only process transactions that involve certified addresses.
Schoar advocated for establishing an infrastructure that allows decentralized entities to collaborate with regulators. That could ensure only participants who follow Anti-Money Laundering, Know Your Client, and antiterrorism constraints are allowed to put transactions on the blockchain.
By doing this, “We could make sure that the blockchain eco-system adheres to these basic standards, at least for the majority of citizens of countries like the U.S. or Europe that agree on these standards,” she said. “If we can coordinate well with them, that means we can actually maintain most of the features of that architecture but protect our economy from illegal activity, including tax evasion.”
The future of DeFi
While innovations in DeFi and crypto might bring benefits in the future — such as the potential to reduce transaction costs — it’s important to remember they are still looking to prove their usefulness, Schoar said. DeFi may create additional problems without adequate regulation, such as tax evasion, given the anonymous nature of the DeFi blockchains.
While DeFi has been billed as a new frontier that’s much more efficient than traditional finance, Schoar said both face a common economics problem when it comes to intermediaries, given that “financial markets are very prone to become monopolized without any intervention,” no matter what universe they operate in.
“How this [DeFi] system evolves, in terms of technology and regulation, has important consequences for liquidity and credit provision to the economy, and ultimately the stability of the U.S. and other global economies,” the authors concluded.